Journal of Financial Economics 25 (1989) 99-122.

North-Holland

FURTHER EVIDENCE ON THE BANK LENDING PROCESS

AND THE CAPITAL-MARKET RESPONSE TO
BANK LOAN AGREEMENTS*

Scott L. LUMMER
Te.rus A & M Universi<v. College Stution. TX 77843. USA

John J. MCCONNELL
Purdue Unioersi{v. War Lu/uyette. IN 47907. ti.SA

Received December 1988. final version received September 1989

This paper investigates the hypothesis that bank loans convey information to the capital market ’
regarding the value of the borrowing firm. Unlike previous researchers. we distinguish between
new bank loans and loan renewals. For new loans, the excess stock return for borrowers around
the loan announcement is not significantly different from zero. For favorable loan revisions, the
excess return is significantly positive: for unfavorable revisions. it is significantly negative. We
interpret these results to imply that banks play an important role as transmitters of information in
capital markets. but new bank loans per se do not communicate information.

1. Introduction

A rapidly evolving view among financial economists is that banks play an

important, and perhaps unique, role as transmitters of information in capital
markets. This view holds that banks either produce or are given access to
information not available to other capital-market participants. Banks make
lending decisions on the basis of this information and the banks’ decisions,
which become publicly available, provide signals about borrowers’ creditwor-
thiness.
James (1987) provides evidence that supports this view. In an event study of
the common stocks of firms announcing bank credit agreements, he reports an
excess return of + 1.93% over the two-day period surrounding the announce-
ments that is significantly different from zero. This evidence is consistent with
the hypothesis that banks play a unique role as transmitters of information in’

*This paper has benefited from presentations at the University of North Carolina, the Gam
Institute of Finance. the Texas Finance Symposium, and the Center for Research in Security
Prices at the University of Chicago: the comments of David Dubofsky. Mark Flannety, Donald
Fraser, James Kolari. William Kracaw, Wanda Wallace, Christopher James (the referee), and Cliff
Smith (the editor): and the research assistance of Horace Ho.

0304-405X/89/.$3.50 c 1989. Elsevier Science Publishers B.V. (North-Holland)

 capital markets, because the average excess return in response to the an-
nouncement of other types of corporate financings is either signiticantly
negative or not significantly different from zero.’ Comfirmatory evidence is
provided by Mikkelson and Partch (1986). In a longitudinal study of 360
firms, they analyze stock returns around announcements of various classes of
security offerings over an 11-year period and report results similar to those
found by other authors, including a significant excess return of +0.89%
around the announcement of bank credit agreements.
To some extent, though, James and iMikkelson and Partch investigate only
part of the phenomenon. Neither study distinguishes between new credit
agreements and extensions or renewals of existing agreements. A fuller appre-
ciation of the bank lending process and the way in which banks transmit
information in capital markets can be gained by making this distinction.
Doing so can indicate, for example. whether banks have an information
advantage over other capital-market participants at the outset of a loan
agreement or whether this advantage comes about as the result of a continuing
working relationship with the borrower.
This paper expands upon the work of James and Mikkelson and Partch by
differentiating between new bank credit agreements and revisions to already
existing agreements. Like James and Mikkelson and Partch, we find a positive
and significant two-day announcement-period excess return for the entire
sample of bank loan announcements. However, when the observations are
divided into announcements of new credit agreements and announcements of
revisions to existing agreements, we find that the positive announcement-period
return is due almost solely to the latter group.
When the sample of announcements on existing agreements is divided into
those in which the credit agreement is expanded or in some other way
improved for the borrower and those in which the agreement is cancelled or
made more restrictive, we find a significantly positive announcement-period
return for the former group and a significantly negative return for the latter
group. We interpret these results as evidence that banks play an important role
as transmitters of information in capital markets.

2. Asymmetric information and the bank lending process

There are at least two perspectives on the way in which banks gain access to
information not available to other capital-market participants. According to

‘See Asquith and Mullins (1986). Dann and Mikkelson (1984). Eckbo (1986). Linn and Pinepar
(1988). Loderer and Van Drunen (1986). and Masulis and Korwar (1986). Smith (1986) summa-
rizes this literature. Two exceptions to this general observation are Kim and Stulz (1988). who
report a positive and significant excess return around the announcement of Eurobond issues. and
Wruck (1989). who documents a positive and significant excess return around the announcement
of private equity offerings.
the first. banks invest in information-gathering technology that gives them a
competitive advantage in evaluating risky lending opportunities. When a
potential borrower applies for a loan, the bank evaluates the borrower, and the
bank’s loan decision signals the prospective borrower’s creditworthiness to
other capital-market participants. Benston and Smith (1976), Diamond (1984),
and Campbell and Kracaw (1980), among others. develop this idea more fully.
If it is assumed that a firm will enter into a new bank loan agreement only if it
currently has no bank financing in place or the terms of the new credit
agreement are more favorable than its current agreement. this line of reasoning
predicts a positive stock-price response when new bank loans are announced.
An alternative view is that banks gain access to private information about
their customers over time as a result of an intimate. continuing business
relationship with them. This idea can be traced to Black (1975) and Kane and
Malkiel (1965). Fama (1985) expands on this theme to argue that banks play a
unique role in providing funds to businesses. Fama’s argument is composed of
two parts. First, bank debt, along with other types of privately placed
fixed-payoff securities, is classified as inside debt. Banks have access to
information not available to holders of the firm’s publicly traded securities or
those who hold other outside claims, such as employees and trade creditors.
Second, because bank loans typically have a low priority among fixed-payoff
claims, signals from the credit renewal process are credible and consequently
reduce the monitoring costs incurred by the firm’s other claimants.
Fama’s argument for the uniqueness of bank loans places considerable
weight on the loan renewal process as a mechanism for transmitting informa-
tion. Loan renewals are important because of the periodic review to which
firms that enter into short-term bank credit agreements submit themselves.
Within this framework, there is no requirement that banks have a competitive
information advantage over other suppliers of funds at the initiation of the
loan. Rather, banks learn about their customers through time as a natural
outgrowth of their business interactions. This line of reasoning suggests that if
there is to be a stock-price response to announcements of bank credit
agreements, the effect should be observed around announcements of revisions
to, not initiations of, such agreements.’ Of course, announcements regarding
loan revisions or renewals can signal either positive or negative information.
For example, a revision in which the interest rate on the loan is reduced or
restrictive convenants are relaxed is likely to provide positive information
about the state of the firm. Alternatively, an announcement in which the credit

‘A variation on this theme is that a firm’s willingness to submit to periodic credit evaluations
may provide market participants with a positive signal concerning management’s assessment of
the firm’s prospects. If so. announcements of new credit agreements should be associated with a
positive stock-price reaction even if banks have no inside information at the initiation of the credit
agreement. In order for this scenario to lead to a separating equilibrium. firms must face a penalty
for false signaling.
102 S. L. Lumnwr und J.J. .McConnell. Bank lounr us slgnuls ojfirm due

limit is reduced or the interest rate is increased is likely to convey negative

information.
The two perspectives on how banks transmit information are not mutually
exclusive. It is entirely possible that banks have a competitive advantage over
other capital-market participants in evaluating new borrowers and that they
also gain access to private information through a close working relationship
with borrowers. Consequently, announcements of both new credit agreements
and revisions to existing agreements can convey information to the capital
market. By distinguishing between new and revisions to existing credit agree-
ments, and between positive and negative revisions to existing agreements, this
study sheds additional light on the bank lending process and the manner in
which banks transmit information in capital markets.

3. Sample selection procedure

To construct a sample, we searched the Wall Street Journal Index (WSJI)
for the period 1976-1986 for announcements concerning credit agreements
between U.S. corporations and U.S. or foreign banks. Only firms with stock
prices on the Center for Research in Security Prices (CRSP) daily file of New
York Stock Exchange (NYSE)- and American Stock Exchange (AMEX)-listed
companies are included in the sample. The search resulted in a sample of 1,145
announcements of bank credit agreements.
Observations are deleted from the sample if other major corporate an-
nouncements are contained in the same article or appear in another WSJ
article on the same day, the prior day, or the following day. Examples of these
‘contaminating’ announcements include announcements of dividends, earn-
ings, stock issues, other debt issues, management changes, acquisitions, ex-
change offers, divestitures, bankruptcy fillings, joint ventures, stock repur-
chases, credit rating changes, and asset sales. In all, 288 observations are
deleted for this reason. An additional eight observations are removed because
we cannot determine whether the WSJ article corresponds to the original
announcement date of the credit agreement. Finally, 121 announcements are
deleted because the CRSP file does not include enough daily returns data for
the empirical analysis that follows. Thus, the final sample contains 728 clean
announcements of bank’ credit agreements.
On the basis of information contained in the WSJ, we initially classify
announcements as concerning new or existing credit agreements. Specifically,
all credit agreements are initially categorized as new if the WSJ either
indicates that the agreement is new or does not indicate that it is a revision,
renewal, extension, replacement, or renegotiation of an existing credit agree-
ment. For those agreements classified as new, we searched each borrower’s
annual report for the year-end before and after the announcement to deter-
mine whether the announcement actually involves a revision of an existing
 S. L. Lummer clnd J.J. McConnell. Bunk louns us srgnals offirm rulue 103

credit agreement. If so, we reclassify the announcement accordingly. Thus, any

credit agreement that is identified by either the WSJ or the firm’s annual
report as being a revision to an existing agreement is placed in the category of
revisions to existing credit agreements. On this basis, of the 728 clean an-
nouncements, 371 are of new credit agreements and 357 concern existing
agreements. Of the new credit agreements, 334 are by industrial firms, and 341
of the revised credit agreements are by industrial firms. The remaining 37 new
credit agreements and 16 revised agreements are by commercial banks and
utilities.
After this search, some ambiguity remains as to whether all of the an-
nouncements classified as new credit agreements actually refer to new credit
agreements with new banks or whether some refer to new credit agreements
with the same bank or banks. For 214 of the 371 observations classified as new
agreements, the annual report states that the agreement is ‘new’, but does not
specifically indicate that it involves a new bank or banks. Unfortunately, the
typical ‘annual report contains a discussion of the firm’s bank credit agree-
ments, including a discussion of the terms of the agreement, but does not
identify the names of the lender banks. However, for 78 announcements, the
annual report indicates that the credit agreement is new and also indicates that
it involves a new set of banks. Thus, depending on the definition employed,
the sample of new loans contains either 371, 214, or 78 observations.*Table 1
provides a frequency distribution of the announcements according to the year
in which they occur.

Table 1
Frequency distribution by year for a sample of 371 new bank credit agreements and 357 revised
bank credit agreements for NYSE- and AMEX-listed companies. 1976-1986.

Credit agreements
Credit agreements with new banks
All credit All new credit denoted as new identified in Revised credit
Year agreements agreements in annual report annual report agreements

1976 X6 37 23 8 49
1977 103 44 25 8 59
1978 94 52 33 15 42
1979 105 62 36 11 . 43
1980 83 49 23 7 34
1981 42 26 9 5 16
1982 66 36 23 8 30
1983 47 17 11 30
1984 47 21 15 : 26
1985 33 18 9 4 15
1986 22 9 7 2 13
- - -
Total 728 371 214 58 357
104 S. L Lumnter und J.J. McConnell, Bunk louns 11ss~gnuls of,th due

Examples typical of announcements of new credit agreements include those

by AVC Corp.:
AVC Corp. said it arranged a $17 million financing agreement with a
group of four banks.
The accord provides for a revolving credit until March 31, 1978, at an
interest rate 0.75 percentage-point over the prime, or minimum,
lending rate. After that date, the credit will convert into a five-year
term loan payable in 20 equal installments. The interest rate for
the term loan hasn’t been determined.
The company, which is engaged in three principal lines of business -
fasteners and formed metal parts, textiles, and television broad-
casting - said the agreement will consolidate its short- and
medium-term obligations. It also will be used partially to fund its
$3.5 million 1976 capital-spending plans.
The banks in the lending group are First Pennsylvania Bank, Citibank.
Cleveland Trust Co., and U.S. Trust Co. (WSJ, July 2, 1976,
P* 19)
and by EG&G Inc.:
EG&G Inc. said it negotiated a $150 million multicurrency credit
agreement with a banking group headed by Morgan Guaranty
Trust Co.
EG&G said the eight-year agreement consists of a five-year revolving
credit arrangement followed by a three-year term loan.
The company said proceeds are to to be used for general corporate
purposes. Initially, EC&G said about $70 million will be used to
replace short-term borrowings used last year to purchase four
million EG & G shares.
EG&G manages projects for the government, including the Nevada
nuclear test site and Cape Canaveral, and makes scientific parts
and instruments. (WSJ, April 12, 1985, p. 45)
Announcements representative of revised credit agreements include those by
Ski1 Corp.:
Ski1 Corp. said it negotiated a $25 million loan with Continenta Illinois
National Bank & Trust Co. of Chicago, First National Bank of
Chicago, and Algemene Bank Nederland N.Y.
The seven-year agreement replaces a three-year credit with the same
banks. The old agreement, which was due to expire next year, had
a current balance of $17 million, the maker of power tools said.
( WSJ, June 16, 1977, p. 31)
 S. L. Lumnwr and J.J. McConnell, Bunk loans us signals offirmdue 105

Table 2
Descriptive statistics for a sample of 371 new bank credit agreements and 357 revised bank credit
agreements for NYSE- and AMEX-fisted companies. 1976-1986.

New agreements Revised agreements

Variable Range Mean Median Range Mean Median

Amount of credit agreement

(millions of dollars) 2.0-3ooO 113.8 40.0 2.0-4800 120.8 45.0
Market value of equity”
(millions of dollars) 2.1-6578 416.4 95.6 1.0-4846 223.7 66.0
Amount of credit agreement/
market value of equity 0.004-7.1 0.66 0.36 0.003-77.8 2.17 0.65
Maturity of credit
agreement (years) 0.5-15.0 6.2 7.0 0.1-15.0 4.8 5.0

aNumber of shares of common stock outstanding multiplied by the market price per share five
days before the announcement of the credit agreement.

and by Genisco Technology Corp.:

Genisco Technology-_ Corp. said it was granted a new $10 million

unsecured revolving line of credit by Bank of America.
The computer graphics and peripheral and electronics company said it
can borrow as much as $10 million at or below the bank’s prime,
or base, rate under the agreement, which expires April 30, 1989.
The agreement supersedes a secured line of credit the bank issued in
1981. Under that agreement, Genisco could borrow as much as $6
million, depending on several factors at the bank’s prime rate over
five years. (WSJ, June 1, 1983, p. 28)

When the information is available, the dollar amount of the loan and the
term-to-expiration of the credit agreement are recorded. Table 2 displays
summary statistics for these data.

4. Methodology

We are interested in the relation between changes in the market value of

common stock and announcements of bank credit agreements. The method of
analysis is an event-time study of stock returns over the two-day period
encompassing the day on which information concerning the credit appears in
the W.9.I (day 0) and the previous day (day - 1).
We use the same empirical procedure employed by James (1987) and
Mikkelson and Partch (1986). For each firm, we calculate excess returns using
106 S. L. Lummer and J.J. McConnell. Bunk louns us srgnals offirm cdue

a market-model benchmark with market-model parameters estimated over a

period beginning 170 days before and ending 21 days before the announce-
ment date. To determine the statistical significance of announcement-period
returns, we compute standardized excess returns by dividing the announce-
ment-period excess return by the respective standard deviation of the predic-
tion error obtained from the market model. We then sum the standardized
excess returns and divide the sum by the square root of the number of
observations to compute a z-statistic. In addition, we calculate the proportion
of announcements with positive announcement-period excess returns, and
conduct a binomial test to determine whether that proportion is significantly
different from the proportion of positive residuals over the period beginning
170 days before and ending 21 days before the announcement.

5. Stock prices and announcement of bank loan agreements

5. I. Full-sample results

Table 3 presents two-day announcement-period excess returns for the full

sample of bank credit agreements and for various subsamples. For the full
sample, the excess return is +0.61%, which, with a z-statistic of + 2.69, is
significantly different from zero. This result is consistent with the findings of
James and Mikkelson and Partch and supports the notion that bank credit
decisions convey information to the capital market. However, when the sample
is divided into announcements of new loans and announcements of revisions
to existing credit agreements, it is evident that the two-day excess return for
the full sample is attributable, almost exclusively, to the latter group. For the
sample of new credit agreements, the average announcement-period excess
return of - 0.01% is not significantly different from zero (z-statistic = - 0.47).
Similarly, for the sample of agreements specifically identified as new in the
annual report and for the sample in which the annual report indicates that the
new loans involve new banks, the announcement-period excess returns of
+ 0.07% and +0.23% are not significantly different from zero. However, for
the sample of announcements concerning already existing loans, the average
excess return of + 1.24% is significantly positive (z-statistic = +4.33). In
addition. the average excess return for the sample of loan revisions is statisti-
cally different from the average excess return for the full sample of new loans
and for the sample of those indicated as new in the annual reports at the 0.05
level of significance. The results are unchanged when only industrial firms are
included in the samples. When the small samples of banks and utilities are
analyzed separately, however, none of the announcement-period excess returns
are significantly different from zero.
 S. L. Lummer and J.J. McConnell. Bunk loons us sign& ojjG-m WIUC 107

Table 3
Average announcement-period excess returns, significance tests. and proportion of positive excess
returns for a sample of 371 new bank credit agreements and 357 revised bank credit agreements
for NYSE- and AMEX-listed companies, 1976-1986.

Announcement-
Announcement- period proportion
Number of period excess z- of positive
Type of announcement observations return (%) statistic excess returns

(A) Full sample of credit ugreements

All credit agreements 728 0.61d 2.69 0.485
New credit agreements 371 - 0.01 - 0.47 0.439
Credit agreements denoted
as new in annual reports 214 0.07 0.41 0.458
Credit agreements with
new banks identified
in annual reports 78 0.23 0.47 0.500
Revised credit agreements 357 1.24d 4.33 0.532’

(B) Revised credir ugreements

Favorable revisions 259 0.87d 3.76 0.556’
Unfavorable revisions 22 - 3.86d - 3.28 0.318
Mixed revisions” 76 3.9gd 4.20 0.513

(C) Credir ugreemenrs with mixed revisions

No prior negative new? 26 2.35 1.51 0.538
Prior negative newsL’ 50 4.82d 4.08 0.500

(D) Credit ugreemenrs wixh unjuvoruble revisions

Cancelled or reduced
by borrower 10 0.16 0.27 0.500
Revised unfavorably
by lender 12 - 7.22d - 4.68 0.167’

‘For the observations in this subsample, some terms of the new credit agreement are more
favorable than those in the old agreement and some terms are less favorable.
bNo negative news concerning the credit agreement was published in the WSJ in the twelve
months prior to the revision.
‘Negative news concerning the credit agreement was published in the WSJ within twelve
months prior to the revision.
dAnnouncement-period excess return is significantly different from zero at the 0.01 level.
‘Proportion of positive announcement-period excess returns is significantly different from the
pryportion of positive residuals during the market-model estimation period at the 0.01 level.
Proportion of positive announcement-period excess returns is significantly different from the
proportion of positive residuals during the market-model estimation period at the 0.05 level.

5.2. Revisions to existing credit agreements

Announcements concerning existing credit agreements can contain either

positive or negative information. To determine whether the market distin-
guishes between announcements on this basis, we divide the sample into three
categories according to whether (1) the terms of the agreement are revised
108 S. L. Lummer und J.J. McConnell, Bank loons us s~pds offirm rulue

favorably, (2) the terms are revised unfavorably, or (3) some terms are revised
favorably, while others are revised unfavorably.
There are four dimensions of a credit agreement by which the terms of a
loan can be revised: its maturity, interest rate, dollar value. and protective
covenants. The protective covenants include such items as a minimum current
ratio, a maximum leverage ratio, and the security pledged against the loan.
Observations are placed in the favorably-revised category if the WSJ article
indicates that the maturity of the agreement is lengthened. the interest rate is
reduced, the dollar value of the loan is increased, or the protective covenants
are made less restrictive. In 43 cases the WSJ article reports that the loan
‘replaced’ an existing credit agreement, but gives no specific information about
the terms of the previous loan. In those cases, we assume that the only
provision that changes is the maturity date, so those observations are placed
into the favorably-revised category. This category contains 259 observations.
The Skill Corp. and Genisco Technology Corp. announcements quoted earlier
are examples of favorable revisions.
The second category contains observations in which the agreement is revised
unfavorably. Either the amount of the loan is reduced, the maturity is
shortened, the interest rate is increased, or the protective convenants are made
more severe. This group contains 22 observations. One way to simultaneously
reduce the amount of the loan and decrease its maturity is to cancel the credit
agreement. This occurs in eight cases. The following announcement concerning
Storage Technology Corp. is an example of an unfavorable revision to a credit
agreement:

Storage Technology Corp.‘s loss of a loan commitment from Chemical

Bank leaves the maker of data storage systems short of cash and
hurts its effort to continue operations.
The Louisville, Colorado-based company said Friday that the agree-
ment between it and Chemical Bank, a unit of Chemical New York
Corp., which would have provided Storage Technology with a $150
million credit line, had been terminated. Storage Technology needs
the funds to continue operations while it reorganizes under Chap-
ter 11 of the federal Bankruptcy Code.
However, Storage Technology said it is negotiating with other financial
institutions for new financing, and a company source said the
‘probabilities are very high’ that the company could find a new
cash infusion in a week or two. Any new loan will have to be
approved by the bankruptcy court.
Neither Storage Technology nor Chemical Bank would comment on
why the credit commitment fell through. Touche R.oss & Co., the
eighth-biggest accounting firm in the U.S., which claimed credit for
 arranging the agreement, couldn’t be reached for comment. (WSJ,
November 19, 1984, p. 4)
The third category contains 76 observations in which some terms of the
credit agreement are revised favorably and others unfavorably. Often, the
announcements describe these revisions as a ‘restructuring’ of the loan. The
following announcement regarding International Systems and Controls Corp.
is an example of a ‘mixed’ revision:
International Systems & Controls Corp. said it signed an agreement
with its banking group for temporary additional financing and
modifications of its collateral in connection with its revolving
credit agreement expiring July 1.
Earlier this month, the engineering, manufacturing, and financial con-
cern said it arranged additional financing, coupled with an increase
in collateral and deferral of certain interest payments to cover
differences between working capital requirements and proceeds
expected from dispositions and collections.
The new agreement doesn’t have a specific maturity date, doesn’t
include a formal waiver of existing default items, and doesn’t
specifically extend the maturity date of the existing agreement, ISC
said. But it is planned to be retired in the near future, the company
added.
ISC said it is negotiating with its banks for sizable periodic debt
reduction and retirement of borrowings outstanding under the
revolving agreement.
ISC didn’t give any details but said it believes the temporary financing
will enable it to deal with its working capital requirements until it
recovers capital from its dispositions and divestitures and collects
major project receivables currently in negotiation. (WSJ, May
31, 1978, p. 40)
The announcement-period excess return for each loan category is presented
in panel B of table 3. The excess return of +0.87% for the sample in which the
terms of the credit agreements are revised favorably is significantly greater
than zero at the 0.01 level (z-statistic = + 3.76), while the excess return of
- 3.86% for the sample in which the terms are revised unfavorably is signifi-
cantly less than zero (z-statistic = - 3.28). These results indicate that the loan
revision and renewal process is an important mechanism for transmitting
information and that capital-market participants respond in a predictable way
to unambiguous announcements concerning the creditworthiness of the bank’s
borrowers. Our results are consistent in one aspect to the findings of Holtausen
and Leftwich (1986): who investigate the information content of bond rating
changes. Similar to our findings, they report a significant negative excess
110 S. L Lummer und J.J. McConnell. Bunk louns USsignals ofjirm due

return around the announcement of downgradings by Moody’s and Standard

and Poors. Surprisingly, they report an insignificant excess return around
announcements of rating upgrades.
For the sample of mixed revisions, the excess return of +3.98% is also
significantly greater than zero and is much larger than the excess return for the
sample of favorably-revised agreements. This result is puzzling in that, a
priori, we anticipated that this class of announcements would convey a less
positive signal about the state of the firm than announcements of purely
favorable revisions.

5.3. A closer look at mixed revisions

We can think of one possible explanation for the highly positive returns
around mixed-revision announcements. Consider why it is in the best interest
of both the lender and the borrower to simultaneously improve some terms of
an agreement and make some terms less favorable. If the borrower cannot
meet certain covenants of the loan agreement, those terms must be relaxed if
default is to be avoided. Other terms are then made more restrictive to insure
that the lender(s) does not lose value. Indeed, many of the mixed announce-
ments indicate that the motive for restructuring the loan is that the borrower
has either violated a covenant of the loan agreement or missed an interest
payment, or that the borrower will miss a future interest payment if the loan is
not restructured. If the borrower’s difficulties are not already known by
outsiders, a mixed revision contains both positive and negative information.
The negative information is that the firm is having financial problems; the
positive information is that the bank has decided to restructure the credit
agreement so that the firm can continue to operate. However, if the market is
already aware of the borrower’s problems, the primary new information
released by the announcement is that the bank - which presumably has inside
information - has decided to continue the loan agreement, albeit with modi-
fied terms.
To explore this issue further, we investigate whether the market reacts
differently to announcements of mixed revisions depending on whether the
potential for default is or is not already publicly known. For each of the 76
mixed-revision announcements, we searched the WSJI for the prior year to
locate earlier announcements concerning the credit agreement. In 50 of the 76
observations, the WSJ previously had published an article indicating that the
borrower was in jeopardy of violating one or more of the terms of the
agreement. In 26 cases, no prior negative information about the loan is
reported by the WSJ. Excess returns for these two samples are reported in
panel C of table 3.
 S. L. Lummer und 1.1. McConnell, Bunk louns as srgnals oj,firm culue 111

To a limited extent, the results are consistent with the idea that more
positive information is revealed when the bank signals its willingness to
continue to work with a firm when it has been previously reported that there is
a problem with the loan. For this sample, the announcement-period excess
return is + 4.82%, which, with a z-statistic of + 4.08, is significantly positive.
For the other 26 observations, the average two-day excess return of + 2.35% is
not significantly different from zero. These results suggest that the market
reacts more strongly when the bank signals its intent to continue to work with
a client known to be in distress. This type of information signal could be
important in helping a struggling firm to continue operations because of its
effect on other parties doing business with the firm. However, the average
excess returns for the two groups are not significantly different from each
other. Of course, in conducting this test, we are relying heavily on information
provided by the WSJ. In some cases, the security market may have informa-
tion that a credit agreement is in distress despite the lack of such a report in
the WSJ. To the extent we have misclassified these announcements, the
announcement-period excess return for this sample is biased upward and’the’
power of our test reduced.

5.4. A closer loot at unfavorable revisions

When credit agreements are revised unfavorably, the action can be initiated
by the borrower or by the lender. Announcements in which the borrower
cancels the agreement are likely to contain less negative information (or even
positive information) than those in which the credit agreement is revised
unfavorably by the bank. The sample of 22 unfavorable revisions is divided
further into a group of 10 cancellations or reductions initiated by the borrow-
ing firm and a group of 12 unfavorable revisions initiated by the lender. The
results for these two samples are reported in panel D of table 3. The excess
returns for the two samples are significantly different from each other. For the
set in which the loan cancellation is initiated by the borrower, the two-day
excess return is an insignificant +0.16; the excess return for the remaining
announcements is - 7.22% with a z-statistic of - 4.68.

5.5. New credit agreements

Except for five cases, all of the firms in our sample that announce new credit
agreements had some prior bank financing in place, albeit with a different
bank. Thus, just as with loan revisions, the new bank loan can be made on
terms that are more or less favorable than those of the old credit agreement.
To classify the terms of each new credit agreement as more or less favorable,
112 S. L. Lumnwr und J.J. .McConnell, Bunk loons us rrgnuls of’firm wiur

we searched the company’s annual reports to identify the terms of both the old
and the new agreement. We are able to identify both sets of terms for 198 of
the 371 new-loan announcements. Among this group, 180 new loans have
more favorable terms than the old agreement and 18 have some terms that are
more favorable and some that are less favorable. We are able to identify no
cases in which all the terms are less favorable than the old agreement. Of the
180 new loans on more favorable terms, 135 are from the set identified as a
new loan in the annual report and 58 are from the set for which the annual

Table 4
Average announcement-period excess returns. significance tests, and proportion of positive excess
returns for a sample of 198 new bank credit agreements for which the terms of the new and old
agreements could be determined for NYSE- and AMEX-listed companies. 1976-1986.

Announcement-
Announcement- period proportion
Number of period excess :- of positive
Type of announcement observations return (%jd statistic excess return?

(A) /Vew credrr ugreemetlts made LWmorefworuhle terms thon prior ugreement

Ail new credit agreements 180 0.17 0.95 0.467

Credit agreements denoted
as new in annual reports 135 -0.13 0.14 0.459
Credit agreements with
new banks identified
in annual reports 58 0.12 0.29 0.466

(B) New credit ugreements with II nuxture of more und less furwuhle terms
reiutrre to prior credit agreementa

All new credit agreements 18 - 0.44 0.40 0.389

Credit agreements denoted
as new in annual report 12 -0.59 -0.18 0.417
Credit agreements with
new banks identified
in annual reports 5 0.04 - 0.02 0.600

(C) New credit agreements with (I mixture o/more and less fworuhle terms
relutiL)e to prior credit ugreement

No prior negative newsb 16 -0.56 0.46 0.375

Prior negative news’ 2 0.50 0.10 0.500

aFor observations in this subsample, some terms of the new credit agreement are more
favorable than those of the old agreement and some terms are less favorable than those of the old
agreement.
b No negative news concerning the old credit agreement was published in the WSJ in the twelve
months prior to the revision.
‘Negative news concerning the old credit agreement was published in the WSJ in the twelve
months prior to the revision.
d No announcement-period excess return is significantly different from zero at the 0.05 level.
eNo proportion of positive announcement-period excess returns is significantly different from
the proportion of positive residuals during the market-model estimation period at the 0.05 level.
report indicates that the new agreement involves a new bank. A similar
breakdown of the new loans with mixed terms is 12 and 5. respectively. To
parallel loan revisions with mixed terms. new loans with mixed terms are
classified according to whether the IKSJ previously has reported that the
borrower was in danger of violating one or more of the covenants of the old
credit agreement.
Excess returns for the various categories of new credit agreements are
presented in table 4. They are easily summarized: in no case is the announce-
ment-period excess return significantly different from zero. Additionally, for
each of the three categories of more favorable new loans (panel A), the excess
return is less than the excess return for the sample of favorably revised loans.
It is significantly less (at the 0.05 level) for the two largest samples. For each of
the three categories of mixed-term new loans (panel B), the excess return is
less than the excess return for the sample of mixed revisions. It is significantly
less for the two largest samples.

5.6. The bank lending process

The evidence indicates that the bank lending process works in the following
way: When a bank enters into a new credit agreement, it does so with no
consequential information advantage over other outside claimholders and, on
average, announcements of new loan agreements reveal no information. even if
the new loan is on more favorable terms than the firm’s old loan. Over time,
the bank becomes privy to information not available to outside claimholders,
and, based on this information, periodically revises the terms of the credit
agreement. If the information available to the bank reflects positively on the
firm, the loan can be renewed or revised on terms more favorable to the
borrower. This decision sends a positive signal to the market. Alternatively, if
the firm is having financial difficulties. the bank can cancel the loan. increase
the interest rate, or tighten various protective covenants. This decision signals
negative information to the market.
There is a third course of action the bank can take. If the firm is having
trouble meeting a particular loan covenant, the bank can restructure the loan
to permit the firm to continue operations. The strength of the signal provided
by this decision depends on what information was previously available to the
market. If the market is already aware of the problem, the stock-price reaction
is more positive than if the problem is first revealed publicly by the loan
restructuring. In short, the data indicate that the bank loan review and
revision process provides useful information to capital-market participants.
The results are not totally satisfyin,. 0 however. If new loan announcements
reveal no information and if information is revealed only as credit agreements
are revised, the average announcement-period excess return across all types of
114 S. L. Lummer and J.J. .McConnell. Rank loons us signuls offirmdue

loan revisions should be zero. That is, on average, excess returns around
announcements in which credit agreements are revised on more favorable
terms should just offset those in which loans are cancelled or revised unfavor-
ably. Contrarily, across all credit agreement revisions, the average announce-
ment-period excess return is positive and statistically significant. One possible
explanation for this phenomenon is that there is a reporting bias on the part of
the firms or banks. They may be less inclined to announce that performance
has been unsatisfactory and that credit agreements have been terminated. An
alternative explanation is that in many cases a credit agreement may simply be
allowed to expire. Such expirations can represent a negative decision by the
bank, but as with dividend omissions, an announcement is not required and
our data collection procedure cannot identify such occurrences. The sheer
difference in the sizes of our samples lends some support to this conjecture.
The sample contains 259 favorably-revised agreements and only 22 that are
revised unfavorably.
Bias could also creep into the sample through our screening process. By
including only clean announcements, we may have screened out a greater
proportion of negative than positive revisions. To investigate the possible
impact of such a bias, we generate the announcement-period excess return for
the entire sample of 456 clean and contaminated announcements of credit
agreement revisions for which return data are available. For this sample, the
average announcement-period excess return is -t-0.81%, which, with a z-statis-
tic of + 2.88, is significantly different from zero. Thus, the announcement-
period return is smaller when clean and contaminated announcements are
used, but it is still significantly positive.

5.7. Other explanatory factors

Our analysis emphasizes the different market reactions to announcements of
.new and existing credit agreements. However, as the descriptive statistics of
table 2 indicate, there are some fundamental differences between new and
revised agreements that might also explain the different market reactions. For
example, for the new credit agreements, the average amount of the loan
divided by the market value of the equity of the borrower is 0.66. For the
revised agreements, this ratio is 2.17. Similarly, the average equity values of
the firms in the former sample are greater and the maturities of the loans much
smaller than those in the latter. As we have discussed, several of the companies
with revised credit agreements were confronting substantial financial prob-
lems. These firms’ equity values are likely to have declined substantially, which
will exaggerate the apparent differences between the market values of the firms
and the relative sizes of the credit agreements in the two groups. Hence, it is
more appropriate to compare the characteristics of firms and loans for
 S. L. Lummer and J.J. McConnell. Bunk louns us signals offirm due 115

Table 5
Descriptive statistics for a sample of 180 new bank credit agreements made on more favorable
terms than the previous agreements and 259 favorably-revised bank credit agreements for NYSE-
and AMEX-listed companies. 1976-1986.

Favorably-revised
New agreements agreements
Variable Range Mean Median Range Mean Median

Amount of credit agreement

(millions of dollars) 3.0-3000 100.7 40.0 2.0-4800 112.3 45.0
Market value of equitya
(millions of dollars) 2.7-2918 285.8 81.4 1.3-4846 262.7 83.4
Amount of credit agreement/
market value of equity 0.04-3.6 0.62 0.41 0.003-33.5 1.10 0.50
Maturity of credit agreement
(years) 0.5-13.0 6.4 7.0 0.1-15.0 5.6 6.0

‘Number of shares of common stock outstanding multiplied by the market price per share five
days prior to announcement of the credit agreement.

favorably-revised credit agreements and those with new loans made on more
favorable terms than the previous credit agreement. Descriptive statistics for
these two samples are presented in table 5. The differences between the two
groups are far less dramatic than those shown in table 2. Still, it is possible
that the loans and the firms in the sample of favorably-revised loans differ
from those in the sample of new loans, and it’ is this difference that drives the
differences in the announcement-period excess returns for the two groups.
Loans can differ on a number of dimensions. We consider four on which we
have data for at least some of the credit agreements: (1) relative size, (2)
maturity, (3) whether the loans are secured or unsecured, and (4) structure
(whether the loan is a revolving credit agreement or a term loan). The various
samples of favorably-revised credit agreements and new loans made on more
favorable terms are categorized on these dimensions and announcement-period
returns are generated. The results, presented in table 6, panel A through D, do
not suggest that the differential in excess returns between new and revised
loans is due to any of these characteristics. For the sample of favorably-revised
loans, the announcement-period excess return is positive for 10 of the 11
subgroups of loans considered and it significantly greater than zero for 6 of
them. Contrarily, for the various samples of new credit agreements, approxi-
mately half of the announcement-period excess returns are negative, half are
positive, and none is significantly different from zero. Thus, on the basis of
univariate tests, the distinguishing characteristic among bank credit agree-
ments - at least so far as the capital-market response is concerned - is whether
the agreement is new or revised.
116 S. L. Lummer and J.J. ,McCo~meil. Bunh louns us srgnnk ojfirm wlue

Table 6
Average announcement-period excess returns, signiticance tests. and proportion of positive excess
returns for a sample of 180 new bank credit agreements made on more favorable terms than
previous agreements and 259 favorably-revised bank credit agreements for ?;YSE- and AMEX-
listed companies with subsamples based on dollar value, maturity. security. and structure of the
credit agreement.

Announcement-
Announcement- period proportion
Number of period excess z- of positive
Sample observations return(F) statistic excess returns

(A) Clussifcution of samples bused on relutiue vulue of the credit ugreemema

All new credit agreements
Relative value < 0.4 g5 -0.13 0.24 0.441
Relative value > 0.4 95 0.44 1.08 0.484
Credit agreements identified
as new in annual report
Relative value < 0.4 -63 - 0.40 - 0.04 0.476
Relative value z 0.4 72 0.11 0.23 0.444
Credit agreements with new banks
identified in annual report
Relative value < 0.4 256 0.56 0.57 0.538
Relative value > 0.4 32 - 0.24 -0.12 0:.406
Favorably-revised credit agreements
Relative value < 0.4 99 0.74 1.87 0.576e
Relative value > 0.4 158 o.94c 3.28 0.544e

(R) Clussijicwiott of sumples bused on mutwit! of the credit ugreement

All new credit agreements
Six years or less 46 0.87 1.69 0.565
Seven vears or more 90 - 0.20 - 0.64 0.411
Maturity unknown 44 0.22 1.11 0.477
Credit agreements identified
as new in annual report
Six years or less 32 -0.19 -0.19 0.420
Seven years or more 69 -0.38 -0.87 0.529
Mat&ty unknown 34 0.45 1.72 0.600
Credit agreements with new banks
identified in annual reports
Six years or less 18 -0.54 - 0.50 0.3x9
Seven years or more 25 0.37 -0.11 0.440
Maturity unknown 15 0.50 1.27 0.600
Favorably-revised credit agreements
Six years or less 101 0.38 1.35 0.505
Seven years or more 94 0.66d 2.05 0.57Je
Maturity unknown 64 1.97c 3.35 0.609=

(C) Clussificution of sumpies bused ott security supporting the credit ug;eememb
All new credit agreements
Unsecured 1x - 0.29 -0.93 0.444
Secured 13 - 0.57 0.42 0.538
Security unknown 148 0.15 1.14 0.459
 S. L. Lummer und J.J. McCormell. Bank loans us stgnals ojjrm due 117

Table 6 (continued)

Announcement-
Announcement- period proportion
Number of period excess z- of positive
Sample observations return (c?c) statistic excess returns

Credit agreements identified

as new in annual report
Unsecured 13 - 1.19 - 1.76 0.462
Secured 13 0.57 0.42 0.538
Security unknown 109 - 0.08 0.62 0.450
Credit agreements with new banks
identified in annual report
Unsecured 6 1.97 0.81 0.667
Secured 7 - 0.41 -0.15 0.429
Security unknown 45 - 0.05 0.10 0.444
Favorably-revised credit agreements
Unsecured 33 2.50C 3.49 0.697’
Secured 19 1.10 1.12 0.526
Security unknown 206 0.60d 2.48 0.539e

(D) Clussificutiott o/sump/es bused ONstructure of the credit ugreemertt

All new credit agreements
Revolving credit agreement 148 0.11 0.82 0.466
Term loan 20 0.46 0.38 0.400
Structure unknown 12 0.47 0.31 0.583
Credit agreements identified
as new in annual report
Revolving credit agreement 114 -0.19 0.15 0.456
Term loan 12 - 0.23 -0.54 0.333
Structure unknown 9 0.87 0.66 0.667
Credit agreements with new banks
identified in annual report
Revolving credit agreement 47 0.17 0.47 0.468
Term loan 6 - 0.47 -0.59 0.333
Structure unknown 5 0.32 0.20 0.600
Favorablv-revised credit agreements
Revolving credit agreement 222 l.OY 4.19 ossl
Term loan 25 - 0.39 - 0.47 0.400
Structure unknown 12 0.25 0.11 0.417

‘Relative value is the dollar value of the agreement divided by the market value of the firm’s
common equity five days before to the announcement. The amount of the agreement is unknown
for one new agreement and two favorably-revised agreements.
bOne new agreement and one favorably-revised agreement were guaranteed by a government or
government agency. Those observations are not included in any of these subsamples.
‘Announcement-period excess return is significantly different from zero at the 0.01 level.
dAnnouncement-period excess return is significantly different from zero at the 0.05 level.
eProportion of positive announcement-period excess returns is significantly different from the
pryportion of positive residuals during the market-model estimation period at the 0.05 level.
Proportion of positive announcement-period excess returns is significantly different from the
proportion of positive residuals during the market-model estimation period at the 0.01 level.
3.8. Multivariate analysis

To further examine factors that might affect announcement-period returns,

we estimate three multivariate regressions for the 259 announcements of
favorably-revised loans combined with the samples of 180, 135, and 58
announcements concerning new loans on more favorable terms than the firm’s
prior credit agreement. In each regression the dependent variable is the
announcement-period excess return and the independent variables are:

Four dummy variables, each indicating whether there is information on a

particular characteristic of the credit agreement. The four characteristics
are (i) the dollar value of the credit agreement, (ii) the maturity of the
loan, (iii) whether the loan is secured or unsecured, and (iv) whether the
credit agreement is a revolving facility or a term loan. If information
regarding a characteristic is available, the respective dummy variable has
a value of 1; otherwise it is zero.
Four dummy variables, each describing a characteristic of the credit
agreement. The four characteristics are (i) whether the credit agreement is
unsecured (coded as a 0) or secured (coded as a l), (ii) whether the
agreement is guaranteed by either a government or government agency (0)
or not (1). (iii) whether the loan is revolving (0) or term (1) and (iv)
whether the announcement is of a new credit agreement (0) or a revision
to an existing agreement (1).
Two continuous variables measuring (i) the logarithm of the maturity of
the credit agreement and (ii) the ratio of the dollar value of the credit
agreement to the market value of the common equity of the firm.

The basic model is

ER;= B,+ xBiXi+e;,

where ERi is the two-day excess announcement return for firm i, B,, . . . , B,,
are the regression coefficients, X,, . . . , Xl, are the variables described above,
and ei is the disturbance term with zero mean. Because cross-sectional stock
returns exhibit heteroskedaticity, both sides of the regression equation are
divided by si, where s, is the standard deviation of the prediction derived from
the market-model estimation. The revised regression equation is

SERi = B,,/si + c BiXi/si + q/s;,

 S. L. Lummer und J.J. McConnell. Bunk loans CISsignuls offirm c&e 119

Table 7
Results of regression of standarized excess returns on various standarized continuous and dummy
variables for sample of 180 new bank credit agreements made on more favorable terms than the
previous credit agreement and 259 favorably-revised bank credit agreements for NYSE- and
AMEX-listed companies, 1976-1986 (r-statistics in parentheses).

Coefficient of variable in percent

Favorably-revised
agreements and new Favorably-revised
Favorably-revised credit agreements on agreements and new
agreements and more favorable terms credit agreements on more
all new agreements on than prior agreement favorable ferns than prior
more favorable terms and identified as agreement. and new bank
Variable than prior agreement new in annual report identified in annual repon

Number of observations 439 394 317

New or revised 0.41 0.49 0.46
(0 if new, 1 if revised) (1.37) (1.83)C (1.13)
Unknown if secured 0.24 0.18 1.18
(0 if unknown. 1 if known) (0.46) (0.34) (1.97)C
Government guaranteed -0.87 2.20 2.10
(0 if guaranteed, (-0.31) (0.65) (0.62)
1 if not guaranteed)
Secured (0 if unknown or -0.10 0.05 - 1.02
unsecured. 1 if secured) ( - 0.12) (0.06) ( - 1.08)
Unknown structure (0 if 0.83 0.73 0.89
unknown. 1 if known) (1.18) (0.89) (0.92)
Revolving or term loan - 0.45 - 0.70 - 0.42
(0 if revolving or (- 1.35) ( - 1.99)C (- 1.06)
unknown. 1 if term)
Unknown maturity -0.21 - 0.63 - 0.42
(0 if unknown, 1 if known) ( - 0.23) ( - 0.67) (-0.43)
Standardized log -0.13 - 0.01 -0.10
of maturity ( - 0.29) ( - 0.03) ( - 0.22)
(0 if unknown)”
Unknown amount 1.09 - 1.43 - 1.83
of agreement (0.38) (-0.41) ( - 0.52)
(0 if unknown, 1 if known)
Standardized relative 0.30 0.27 0.25
value of agreement (1.70)’ (1.51)’ (1.36)
(0 if unknown)b
R-squared 0.02 0.03 0.03

aComputed as log of the maturity of the credit agreement divided by estimated standard error
ofbtwo-day return.
Computed as amount of the credit agreement divided by the market value of equity. and
divided by estimated standard error of two-day return.
‘Coefficient is significantly different from zero at the 0.10 level.
where SER, is the standarized announcement-period excess return for an-
nouncement i.
The regression results are presented in table 7. The coefficient of the dummy
variable indicating whether the loan is a revision or new is positive in each
regression, but is significantly greater than zero at only the 0.09, 0.04, and 0.13
levels. respectively, for the three samples. Thus, the results are consistent with
(albeit at weak levels of significance) the hypothesis that announcements of
favorably-revised bank credit agreements provide a positive signal to outside
claimholders and that announcements of new bank loans do not.

6. Summary and conclusion

Previous documentation, by James (1987) and Mikkelson and Partch (1986).
of positive excess stock returns surrounding announcements of bank credit
agreements appears to show that banks are a unique source of corporate
financing. Our analysis suggests another interpretation of the data. When a
sample of bank loan announcements is split into those concerning new credit
agreements and those concerning revisions to existing agreements, the former
set has virtually no impact on stock prices, while the latter group has a
significant excess return of +1.24%. The absence of a significant market
reaction to announcements of new bank loans is consistent with studies that
report an insignificant market reaction to the announcement of new public
debt issues and new private placements of debt.
Further analysis of the sample of credit agreement revisions indicates that.
as suggested by Fama (1985), the bank loan review and renewal process plays
an important role in transmittin g information in capital markets. Announce-
ments of favorable loan renewals and revisions are accompanied by a stock-
price increase, while announcements of loan reductions and cancellations are
accompanied by a stock-price decline. Further, when the loan cancellations are
initiated by the bank, the stock-price reaction is even more negative than
average, whereas when the cancellation is initiated by the borrower, there is no
stock-price response. This result indicates that it is the action of the bank,
rather than the borrower’s decision about to the use of debt, that signals
information.
Finally, the strongest positive stock-price response is associated with an-
nouncements of loan renewals for which previously-published information
indicated that the loan was in trouble. Typically, these announcements involve
a restructuring of the loan that will allow the borrower to avoid technical
default. In exchange, the bank receives additional security or a higher interest
rate. In either case, the bank - presumably on the basis of inside
information - is signaling its intent to continue to work with the borrower.
Apparently, the market interprets this as a very positive signal.
 S. L. Luntmer and J.J. .McConnell, Bmk louns us s~gnois ofjhn due 121

The analysis leaves us with one unsatisfying result. If investors form

unbiased expectations and if the loan renewal process is only signaling
borrowers’ creditworthiness, the average stock-price response across all an-
nouncements of credit agreement revisions should be zero. For our sample, the
average response is significantly positive, suggesting that either our sample
selection procedure is biased or that loan renewals and revisions, on average,
create value. The problem with the second interpretation is that, if the renewal
and revision process creates value and if investors form unbiased expectations,
value should be capitalized when new loans are announced, and the average
stock-price response at the initiation of the loan should be positive and
significant. It is not. We are thus lead to the conclusion that our sample
selection procedure is biased, probably because firms and banks are less likely
to announce negative than positive information.
Our results do not support the contention the banks are unique in the sense
that they possess a competitive advantage over other lenders in making credit
decisions at -the outset of a loan. At least any uniqueness in the bank credit
decision process does not manifest itself in a stock-price reaction for corporate
borrowers when the establishment of a credit agreement is announced. How-
ever, the results do support the view that decisions made by banks as a result
of a continuing lending relationship with a corporate borrower serve as
influential signals of firm value. Thus. the results indicate that banks are
important and credible transmitters of firm-specific information to the capital
market.

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